The Brexit Negotiations – a German Perspective (Part 2)

Editor’s Note ~ This is the second part of an article republished with the kind permission of CIB. You can read the first part here.

IV The EU Chicken Game Theory Negotiation Guide

The political intention behind the use of these fog grenades is easy to discern and one could even have a certain tolerance for it, if it was just about the creation of a rational negotiation strategy. The problem is: Europe’s politicians have told this to each other so often in their echo chamber that by now they really believe it! They have fallen prey to their own propaganda.

The result of this giant echo chamber of mutual self-assurance and stew of self-righteousness is the conviction that the Brexit negotiations are inherently a game of chicken. The one who first blinks will lose. The concept is completely insufficient to capture the inherent complications of the problem, but also pretty obviously overtaxing the intellectual capabilities of its proponents. The enemies in this game of chicken are not just the insubordinate secessionist rebels in London, but all countries and political forces toying with the thought of following their example; or those just daring to remind the Bureaucratic Party of the principle of subsidiarity in an “ever closer union”. They shall get a pre-emptive lesson that it will be painful to spurn the intrusive love of those who define their political raison d’être in attaching their tentacles to other people’s fridges.

This theoretical toxic waste is even articulated by some professors who belong to the close circle of advisors of the German government. It is though pretty obvious that the question as to what game we are playing is far from resolved. This game is not one of chicken. It is not an “I win you lose” game. That is only the case in the thin intellectual reasoning of people who would do well to learn about the assumptions and limitations of game theory before they employ it and turn it into a guide for their political war cry.

Looking at the economic and technological realities mentioned above makes it clear this game rather is a prisoner’s dilemma. Incentives for cooperation will be switched off on both sides as a result of the erosion of trust. This is a sorry state of affairs that will produce losers only. The ability for critical reflection has been degraded and degenerated by this exercise in such a way that old and proven principles of behaviour and respect in the mutual dealing between sovereign nations have gone overboard.

This is specifically true regarding the respect for the territorial integrity and sovereignty of the United Kingdom. Quotes bubble up from Europe’s capitals about the desire for secession of Scotland, Northern Ireland and Wales, even of London! The NATO ally Spain is encouraged to abuse the opportunity for a Gibraltar debate by giving Madrid a veto over a matter they had not even asked for.

Instead of minding their own business, they are minding the business of a sovereign nation in a completely outrageous way. Why? Because they do not view members of the EU as sovereign states with sovereignty embodied in the will of their people. This is the Juncker version of the Brezhnev doctrine. EU member states are viewed as provinces which have to be administered for the advantage of the administrators and whose population (note: not People!) is granted the privilege to occasionally applaud in an acclamatory fashion in order to demonstrate their gratefulness.

In clear denial of the facts it is being claimed that for Scotland there is indeed a new situation after Brexit justifying a new vote on independence. When Scotland voted, the Brexit vote had already been scheduled. Everybody knew it could go either way. So Scotland voted, in the full knowledge of the possibility of Brexit, for the continued Union with England. What then is the new fact on the ground? Would another outcome of the vote also have constituted a reason to vote again? Do we want to turn every democratic decision of political significance in the future into a reason to split up nations after centuries of common history due to regional differences in the voting result?

The whole debate is testament to the abysmal disdain of the Brussels bureaucrats and their satraps for the voter’s will and the expressions of this will by the people. Polls are accepted only if they fit their purpose. Especially with regards to European matters we have seen it more than once that people were called to the polls until the result was compliant. In this sense Ms. Sturgeon is a docile padavan to her Brussels masters: Repeat the vote until you get what you want and then lock that in. This lack of democratic credibility is a central Leitmotiv of the EU`s governance, where the composition of every decision making body is s the result of horse trading instead of universal suffrage.

There is a reason why the term “one man – one vote” originated in the English language. We even use the English term in Germany quite frequently. This reason is the historically developed democratic tradition on the island. And this is the very same reason, why the British have a deep rooted aversion against undemocratic bureaucratic elites. And it will be damned difficult to exorcise it out of them.

V The German Government’s Situation and Position

Let me briefly talk about the German governments political motivations. The first element driving the German government into the arms of Mr. Barnier’s confrontational approach is the budgetary aspect. The UK is, together with Germany, the only other net contributor of significance to the EU-Budget. The expectation that the sycophants in the Berlaymont will not reduce their subsidization and redistribution schemes because of Britain’s departure can be taken for granted. Getting a budget under control, let alone reducing one is totally anathema for this “class distributif”.

Germany alone has not nearly enough votes in the EU Commission, the council, or any other common institution to organize cuts in line with the smaller size of the budget available. In every European council exercising power, from the commission to the ECB, the rule of “one country – one vote” leads to the absurd result that the weight of a voter is inversely proportional to the size of his country’s population. In the doubtlessly most influential body on the continent, the ECB council, a Maltese voter has the weight of 204 German voters. That probably reflects the fact that a Maltese understands monetary theory and policy 204 times as well as a German citizen. I dare to call this sorry state of affairs a special form of apartheid. It contradicts democratic principles and traditions and an institution with the ambition to replace democratic nation states cannot claim any legitimacy on such a basis.

And even though Germany does have some leverage, albeit not de jure but de facto, Merkel does not want to use it as a matter of principle – unless forced by circumstances. If the outcome of the recent elections can contribute to this remains to be seen. I would so far say it didn’t. So, not willing to pick a fight over budget reductions and savings in the corridors of the Berlaymont, chancellor Merkel has decided that the Brexit bill is of utmost importance to limit the additional demands directed at Germany. To blow it up to €100BN would imply that Britain’s net contributor position is preserved for a decade or so at current levels. Needless to say, the coalition formed by these interests will not want to give anything back in return to the UK taxpayer.

Deflecting these demands from Britain can only be managed by disputing the components of the bill line by line, demanding value added in return, a quid pro quo, because that was also part of the deal in the past. And free trade is certainly not a quid pro quo in this sense, because both sides profit from it from the start, the EU even more so than the UK.

There is a second element which I believe has a large influence on a number of key decision makers in Berlin, especially on our very powerful finance minister Wolfgang Schäuble. He is part of a generation of politicians with a genuine “faith” in the EU as the central “project of peace” on the continent. This group does not believe that they can succeed in building a new version of the Europe des Patries that the founding fathers dreamed of if the existing institutions are demolished and hence support the misguided idea of an “ever closer union”. For that reason they don’t see the original vision as an option any more. What they see being endangered is no less than their lifetime achievement. This is no weak force for inhibiting sound judgment.

The problem they face is the timely coincidence of Brexit with the €uro-crisis. They know that it is impossible to push the southern European countries towards the market reforms necessary to enable their economic survival inside the €urozone. They have tried and failed repeatedly. However the €uro is of such centrality in the ideological edifice they have erected that it is being defended come hell and high water even in the face of complete absurdity, unsustainable cost and life threatening risks.

The €uro, however, is the time bomb that will likely blow up the European institutions in a single cataclysmic event. I am convinced it will do so during the next German government’s term in office. The reason is simple. The Euro has created huge trade imbalances inside the Eurozone. Goods and capital have been flowing from a super competitive Germany (for which the €uro is undervalued) to a decrepit “Club Med” (for which the €uro is overvalued). As a consequence, unsustainable levels of debt held by Germany through a variety of vehicles have been accumulated. At risk are bonds bought by German institutional investors (€1.8 TRN), the ESM commitments as part of the “Euro-rescue” efforts (€200 BN), and the Target-2 exposure.

Target-2 is an overdraft loan the Bundesbank has handed out at zero interest, unlimited, unsecured, for indefinite time and without any control or discretion to the other central banks of the €uro system. As of September 2017 it added up to €850 BN. I call this combined approximately €2.8TRN exposure my country is running, “the biggest hedge fund on the planet with one single bet, namely that the €uro will be saved”. The problem with this sort of policy is that it creates imbalances in the real economy which cannot be kept under the rug forever. Specifically the flat yield curve at zero level erodes the earnings power of commercial banks. Our calculations show that most German and indeed EU commercial banks will start suffering substantial operational losses from 2019/20 onward.

This translates into shrinking risk taking capacity of the banks which in turn leads to shrinking credit volumes, shrinking bank money creation and deflationary pressure. Paradoxically the desperate push for more inflation thus will create deflation.

Furthermore, the zero interest rate environment has kept hundreds of thousands of companies in business that would have gone bust under normal cost of capital conditions since 2007. Thus, it created what I call an army of corporate zombies which infect the banks credit books with junk quality loan exposures. These companies will fail in the event of rising interest rates or a downturn in the business cycle. Their breaking wave of defaults will likely lead to losses north of €1,500BN for the €urozone banking system taking down more banks than the US mortgage crisis did.

While refusing to acknowledge this publicly, the German government has been made acutely aware of these imbalances as the OECD, IMF, BIZ and a number of private institutions have all confirmed the estimate that so called zombie firms are by now making up 9-10% of Europe’s total number of firms. It reinforces the stance of Juncker, Barnier, Merkel and Schäuble that they must avoid cracks appearing on the facade of the remaining EU-27. Politically they cannot afford to lose a single additional country. Not from the EU, and not from the €urozone, as leaving it automatically involves a trigger to leave the EU.

VI The Leverage the UK can apply

Now, how does this play into the Brexit negotiations? Paradoxically, this situation could be leveraged by the UK to the advantage of a constructive negotiation strategy. It might be a winning strategy to put some focus on Berlin in the coming months. This has several reasons:

It is of utmost interest for Germany to avoid being pushed into an even higher net contribution after Brexit. This can either be achieved by an outrageous Brexit bill for the UK or by savings in Brussels. The UK needs a clear communication strategy to the German public and political decision makers that spending in Brussels necessitates big cuts. A targeted PR strategy focusing on Germany might be worthwhile to be considered. The EU-27 have a 120 BN €uro trade surplus with Great Britain, much of it coming from the bilateral trade between Germany and the UK, much of it easily substituted from other sources. When I attended a presentation of a Ministry of Finance official to the commission of the Economic council for the Financial Industry a few months ago this matter was brought up in the subsequent discussion. It very quickly resonated with the representatives of companies and banks that were present. However, before the number was thrown into the debate, 95% of the participants were unaware of it.

The resulting question for the UK negotiators is: How can public awareness be built with the effect to create political awareness? The security debate in Germany is heating up. The influx of 1.5 Million refugees from Syria and North Africa, 85% of them young men, into Germany has created a severe public security problem. Germany has dropped to rank 51 in the global travel security index and now trails behind Rwanda, Morocco, Korea, Albania, Azerbaijan and Tajikistan. Cooperation with the one country in Europe that is leading in electronic intelligence is therefore imperative for our security. That fact alone creates a certain level of leverage through mutual interest and it would not hurt reminding Berlin of this.

We are also witnessing an increasing tendency for the Russian bear to flex his muscles. At the same time our American friends are dealing with an internal constitutional crisis. It is clearly of the utmost importance for the European members of NATO to step up their own defence spending and reinforce their mutual defence commitments. Here, realistically there are three, possibly four relevant countries: UK, France, Germany and Poland. The survival of the EU is conditional on the continued willingness of the militarily significant European members of NATO to work together for mutual defence. The critical decisions will be taken in Berlin, Paris, London and Warsaw – not Brussels. Again, it is clear that the UK would not use this as a point of leverage, but Berlin can be obtuse when it comes to issues of defence and it would not hurt to remind the Chancellor of these matters.

Why do I believe this collection of German interests is relevant for the UK? Because while we have seen above what the current drivers of the Merkel administrations behaviour are, it is also clear that she does have a huge leverage over the other key players, namely Macron, Juncker, Barnier and the governments of the southern periphery which she is reluctant to use: The monetary policy of the ECB which currently accommodates the unwillingness to reform Italy, Greece, Portugal and others could not be conducted without Merkel’s tacit approval. Draghi wants to continue this as long as he presides over the ECB-council in 2019.

France’s president Macron has aimed for a mix of timid reforms and more intra-European redistribution. Transfers and socialization of risks through schemes like Eurobonds, etc. are his goals. There will be some sort of deal of money for reforms and although I don’t think it will work, he is looking to Berlin for help. President Macron’s biggest worry currently is that the liberal FDP opposed to this, gains too much strength in a future German government.

Italy needs, apart from the continuation of the ultra-loose monetary policy Berlin’s tacit approval to rescue more of its banks with tax payers’ money in violation of the new treaty regulating failed banks resolution, a move that will create more debt and more target-2 transfers from the Bundesbank to the Banca d`Italia.

To summarize it: Germany is the one country in Europe that can least afford to let the Brexit negotiations fail. And it is the one country with the largest leverage over the negotiations while at the same time refusing to use it. This may have some implications for the UK`s negotiation strategy. I also think any discussions need to take place at the very highest level; power is concentrated in my country and it would take a rare courageous minister to buck the line coming from the Kanzleramt.

However, make no mistake with regards to Chancellor Merkel’s attitudes. She will not be helpful to the UK without the application of what I would call “constructive pressure” changing her European equations in favour of a balanced result of the negotiations!

VII Concluding Remarks

Honourable members of the House of Lords, Ladies and Gentlemen, The Prime Minister of the United Kingdom during its finest hour, Sir Winston Churchill, whom I regard as the greatest statesman of the 20th century, and whom I hold in the highest esteem for liberating Europe and my home country, once coined the immortal phrase: “The truth is incontrovertible. Malice may attack it, ignorance may deride it, but in the end, there it is.”

For me in this matter there is one simple truth: The British people have made a democratic decision in line with your best traditions, values and a vision of Britain that recaptures and preserves its state of liberty, freedom and democratic patriotism, a role model for a free and prosperous Europe. They have done this because they observed that those values collide with the direction the EU has taken. This decision is to be respected and this is a truth that is currently attacked by malice, derided by ignorance, but in the end, there it is.

7 Comments

Promises, promises. That’s what mainstream politicians do best, anything to get our votes. Both Corbyn and May both know most people want to leave the EU, so they promise to deliver Brexit whilst quietly working towards the opposite.
Somehow we have to convince the public that our “masters” don’t like the result of the referendum and can’t be trusted to do as we demanded. At the same time we must have broad brush policies in place for after we leave, if it ever happens at all.

Roger Turner
on November 15, 2017 at 11:53 pm

Excellent articles, but I believe there is a supreme consideration that does not get a mention.
Yes, Politics is discussed and so is Finance.
but what has happened to POWER and the strategy for attaining it.
The ambition is for a formal United States of Europe, taking its place as a power bloc in world affairs, to display the necessary accompanying power, it will require a full integrated Army/Airforce/Navy centrally funded and commanded, it will also require full fiscal integration.i.e all nation states will cease to exist and sole sovereignty must be transferred to Brussels.
It is understandable why the Euro must be sacrosanct, but there is one fly in the ointment, power will not be complete without the EU having a dedicated permanent seat in the Security Council; after Brexit they will only have the French one available.
Imagine Brussels Central Office (Germany really) having to propitiate the French every time they wanted to make an international military move; without the dual balancing seat power of the UK, they can never be regarded as a fully fledged international power.
For me that`s the main reason they are trying so desperately to hang on to us.

Howard Keating
on November 15, 2017 at 8:22 pm

These two excellent articles should be compulsary reading for the UK’s Brexit team.

citizenkain
on November 15, 2017 at 12:54 pm

The two articles by Dr Krall just confirm my optimism
Sufficient rock solid support for BREXIT in England will make a project remain politically impossible with or without UKIP in its present emasculated form.
In simple numbers there is no more than 2million voters pushing for remain (the remainiacs)irrespective their influence and affluence.
At the least there are ten million voters who remain firmly for hard brexit (the BREXITEERS).
Given that Italy is in severe financial difficulties and the GE nxt May will be won by parties favouring Quitaly plus the continued terrorism in France and Germany plus the hard line of Visegrad5 means that in 2 years from now 30%+ of EU citizens will be on the side of braking up the corrupt monster.
Patience and shuffle the cards – we already have 4Aces on our side

RichardW
on November 15, 2017 at 4:49 pm

I hope you are right, CitizenK, but at the moment I do not share your optimism about Brexit.

I do not know what the voters think, but I do know that both Houses of Parliament, the civil service, the mainstream media, the universities and, one assumes from the Gina Miller case, most of the senior judiciary are all firmly in favour of the UK staying in the EU.

This is a very powerful coalition of interest groups. Can they be trusted to deliver a real Brexit?

Brenda Rattle
on November 15, 2017 at 6:38 pm

“Can they be trusted to deliver a real Brexit?”

Sadly, I think the answer is No.

RichardW
on November 15, 2017 at 12:05 pm

Another brilliant article from Dr Markus Krall – I only wish he were heading up our Brexit negotiating team!

His article is worthy of deep study from anyone interested in achieving a real exit from the EU for the UK.

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